Tuesday, January 08, 2008

Understanding and Making Use of Relative Strength

If you manage your own IRA or 401K, or have any interest in the stock market, this is one of the most important entries you'll read anywhere this year. I asked frequent contributor Harun I. to explain and illustrate "relative strength." The motivation is that I have learned from him how powerful this simple concept can be for investors professional and non-professional alike.

Some very popular bloggers have recently offered advice along the lines of "the best you can do is lose less of your capital than everyone else." For those of us without great scads of capital, or the desire to actually increase our purchasing power rather than watch it decline, this is cold comfort indeed. My own goal is to increase my purchasing power, i.e. increase my capital in real terms. I have no interest in losing, even if it is relatively less than others.

Which brings us to relative strength. The reason why this metric is so powerful is that it can help us identify those sectors or stocks which are outperforming other sectors and indices. While I understand the appeal of an unchanging investment strategy--only buy gold, or index funds, or TIPs bonds, etc.--the reality is various investments outperform other investments, and it does not require the dark arts to ascertain what is outperforming other possible investments.

The investor who manages to buy into those assets which are outperforming others, and then switch at the appropriate juncture to the next outperforming asset, (or short the assets which are underperforming) has the potential to actually increase his/her purchasing power, not just lose less than the next poor bloke.

As I have stated here before, my primary thesis is that no single investment strategy will guarantee increasing purchasing power in the tumultuous years ahead. Even those mighty engines of apparently endless outperformance, gold and oil, may yet underperform other assets. To be blind to that possibility is, well, dangerous to capital growth, not to mention capital perservation.

Here are Harun's comments, with charts which can be expanded into new windows by clicking on them. If you take amoment to study each chart, the fundamental ideas will become clearer.

The salient question of most investors and even traders is what and when should I buy or sell? Before the Internet the majority of people either listened to their brokers or opted for professional management via mutual funds. With access to the markets and information made easier by innovations in technology many want to forgo the advice and fees of a broker and step up to the task of managing their investments themselves.

But with so much information and so little time how does one sift through the deluge of information and by what metric(s) does one compare asset classes, sectors, and individual instruments? Should you throw darts, listen to the financial MSM, or diversify until your returns are so diluted your financial goals may never be realized? (It is not that I don’t believe in diversification, what I find unacceptable is diversification based on hope rather than a solid rational). While I offer no definitive answer I hope to provide information that will arouse curiosity.

For market technicians one of the simplest answers comes in the form of what is called ratio analysis or, more commonly, relative strength (RS) analysis. RS is not to be confused with Welles Wilder’s Relative Strength Index (RSI). Whereas RS compares two separate instruments, RSI compares an instrument to itself over n periods.

Expressed as a rational number a/b, understanding how to read an RS chart is simple: when the line is rising (a), the numerate instrument, is outperforming (b), the denominate instrument. And when the RS line is falling (b) is outperforming (a). RS will not tell you the direction of price of the compared assets or instruments.

RS can be used in many ways. It is most useful in determining outperforming assets into which on can employ a strategy for a diversified portfolio; here I will use RS to compare a monetary asset against a sector index to determine the gain/loss of purchasing power. I will then use RS to compare an individual instrument from the sector to ascertain its performance against its parent index and broad market index (did it make more sense to own the index instead of the stock?), and RS will be used to compare the individual instrument against a monetary asset to see whether it is losing or gaining or unchanged in purchasing power.

Gold will be used as the monetary asset. I can hear the arguments now that gold has been demonetized but unless one has been living under a rock it is clear that gold is acting like money. I could use a commodity index as a hard asset but then there would be arguments over the weighting of commodities in the index.

In this first chart is the SP Financial Index compared to gold. From 1989-2000 the trend of RS line indicated that there were better returns to be had owning the SPFI that owning gold or commodities. Purchasing power increase as well in that more gold or commodities could have been purchased in 2000 than at the time of the initial investment in 1989. The price levels during 1989 suggest that buying the SPFI was relatively inexpensive. The 1998 and 1999 peaks of the RS line and the peaks of MACD diverged indicating for the first time that the acceleration of this trend had changed at the primary level.

The third divergent peak occurred in 2001 and the reversal of the RS line and price was confirmed in 2002. The RS line falling into a downtrend indicated that the SPFI or the financial sector was beginning to under-perform gold. The SPFI price chart developed a Head and Shoulders top pattern that failed to complete to the downside, which usually means significant upside in prices ahead.

After the final bottom in price and RS in 2003 price rose while RS remained flat and eventually entered into a down-trend indicating that while price of the index rose the amount of what it could purchase fell. At this point the investor should understand, in this sector, money is being made but purchasing power is being lost at a higher rate and that a defensive strategy should be employed.

Backing up, now that we know that the financial sector may be a reasonable investment, let’s look at the performance of one of it largest and most popular stocks, Citigroup, NYSE C, and look at how this stock performed over the same time period. In this second chart Citigroup is compared to gold. During the 1989-1991 period while the sector was out performing gold (increasing purchasing power) Citi failed to do so. Therefore, without looking at other stocks in this sector, it made more sense to own the index than Citi.

Then next chart to examine is the Citi/SPFI ratio chart. Here we see that Citi under-performed its sector index during the period in question and examining the Citi/SP 500 RS chart, Citi under-performed the broad market index as well. What this all says in a nutshell is that during the 1989-1991 period there were better places to invest one's capital than Citigroup.

This changed across the board in 1992. From this point forward we see Citigroup’s out-performance in all comparisons. In 1994 the RS charts with the exception of gold had peaked and turned down until 1998. The gold RS bottomed in 1995 and headed up signaling Citi’s increasing purchasing power but sub-par performance against the broad market and sector indices.

The final highs of the RS charts came in around 2000-2001, and bottomed in 2002 rallied briefly then diverge from price dramatically, and accelerating to the downside in the latter part of 2007.

A review of Citi’s price chart since 2002 reveals that during a time of outstanding profits and billions in bonuses on Wall Street Citi’s price activity was anemic, it simply did not confirm the fundamentals. The discreet signals of the RS charts could have, if heeded, given warning that not only was Citi no longer performing well but the entire sector was under-performing despite the media and industry propaganda.

The yearly price chart of Citi shows what can happen when markets become greatly distorted. The buy and holders in this instrument gave back fairly sizeable nominal gains. But real gains have eroded the greatest since 2001 not 2007.

This has probably sparked more questions than it has answered, but that is the point. A door has been opened; walk through if you choose. Look around and see if there is anything useful; let curiosity fulfill its purpose.

Thank you, Kip S. ($50), for your on-going generous support of this humble site. I am greatly honored by your contributions and readership. All contributors are listed below in acknowledgement of my gratitude.

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